Aurora Borealis
1 June 2015 CFA Institute Journal Review

Dodd–Frank and Risk in the Financial Services Industry (Digest Summary)

  1. Sadaf Aliuddin, CFA

Learn how the Dodd-Frank Act impacted risk in the financial services industry. The effects of Dodd-Frank have been positive on industry risk.

Implementation of the Dodd–Frank Act has resulted in reduced risk in the financial system. Improved capital ratios, decreased levels of nonperforming loans, and increased governance oversight by banks in compliance have significantly reduced systemic risk, which was the objective of the legislation.

What’s Inside?

The goals that drove the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd–Frank Act) were to reduce systemic risk in the financial system and to end the idea of financial institutions that were “too big to fail.” The authors present evidence that the legislation appears to be achieving those goals because discretionary risk taking by financial institutions has declined since the enactment of the Dodd–Frank Act. In addition, the impact appears to be having a lasting effect because it is more evident over longer periods of time, as seen in the reduction of return variance. Strong governance frameworks also play a significant role, and larger institutions accordingly witness a greater risk reduction.

How Is This Research Useful to Practitioners?

A key objective of the Dodd–Frank Act is to improve accountability and transparency in the US financial system, leading to stability in the system. The authors’ findings are useful from both regulatory and investor perspectives because they indicate that risk awareness and control measures in financial institutions have improved. The research also should be encouraging to international investors that have exposure to US markets.

The authors first establish that there is a decrease in variance and institution-specific risk and then establish the extent to which different types and sizes of institutions have been influenced. The larger institutions have experienced a greater reduction in risk despite the removal of the implied protection for “too big to fail” institutions, one of the core objectives of the legislation. Surprisingly, governance measures are not significant determinants of risk taking in banks that are already highly regulated externally.

How Did the Authors Conduct This Research?

The authors select 694 institutions, of which 520 are depository institutions and 174 are nondepository institutions. The available universe is identified by using the standard industry classification (SIC) codes. To be included in the sample, the institution had to have return data from at least 300 trading days before the first event leading up to the introduction of the Dodd–Frank Act (2 December 2009) to 300 days after the legislation was signed into law (21 July 2010). Data are from CRSP. Using regression models, the authors estimate changes in four risk measures, including variance, beta, and two estimates of unsystematic risk, across four time horizons in pre- and post-Dodd–Frank Act periods.

To measure governance risk, they use three measures: the Corporate Library (TCL) governance rating, institutional ownership, and insider ownership. The qualitative TCL rating is converted into a score between 1 and 5, with 5 being the best governance score. An increased level of institutional ownership also improves the risk profile because of the higher level of monitoring mechanisms.

Abstractor’s Viewpoint

The authors’ work is useful from both regulatory and investor perspectives. It provides evidence for investors of improved risk awareness and control measures in financial institutions. The disturbing part of financial institutions taking risk is the systemic effect it can have. Consequently, the whole system can be affected and not just the direct investors in a particular institution.

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